Buying a Rental Property vs. a Typical Mortgage or Second Home | The Simple Dollar

Buying a Rental Property vs. a Typical Mortgage or Second Home | The Simple Dollar

If you’ve purchased a home or property at some point in your life, you might think you’re prepared for the process of buying a rental property. That may not be the case, though. The financing process for rental properties can be quite different than it is with other properties.

When you buy a rental property, don’t expect the loan steps to be like they were for a mortgage on your primary or vacation home. Banks treat these types of loans differently because you won’t be living in the house and will be treating it as an income source, which makes it a riskier move for them to finance. If a financial crisis occurs, it’s less likely that a rental mortgage would be paid than the mortgage on a primary residence, so it’s harder to get a loan for this type of property.

If you want to invest in a rental property, you need to know everything about the financing process before you take the leap. Whether it’s info on mortgage rates or insight into the down payment requirements, here’s what you need to know and what to expect before you get started.

What is a rental property?

A rental property is a property that you purchase with the intention of renting to someone else after you purchase it. This type of property is considered an investment property. The initial investment is the price of the property and any upkeep that’s necessary. The return on the investment is the rental income the owner brings in.

Rental properties can take many different forms. A rental property you purchase could be a single-family home or be in a multi-unit building. It could be a commercial building, a standalone house in the country or a condo in a metro area. There are also different forms of rentals. The property could be rented out to long-term tenants or used to make money through short-term rentals like Airbnb.

It’s also important to differentiate between residential and commercial rental properties. A residential property could be a house, duplex, apartment, townhouse or another type of property that someone might reside in. A commercial property is one where the units are rented out to businesses rather than individuals.

Rental properties are a consistently popular investment opportunity. In a 2019 Gallup poll, 35% of Americans listed real estate as the best long-term investment. Many people who invest in real estate choose to finance the property rather than paying for it in full. Doing so allows them to receive a monthly cash flow, some of which goes toward the mortgage payments.

Rental property mortgages are available through many of the same lenders you might use to get a regular home loan. But while the lenders overlap, these loans often come with different terms and retirements than home loans do.

[ Read: What I Wish I Knew Before Buying a Rental Property ]

How are mortgage rates different for rental properties?

Mortgage loans offer some of the lowest interest rates you can get on any type of loan. Before you start shopping for a rental property, though, keep in mind that interest rates on investment property mortgages are almost always higher than the typical market rate.

When lenders approve a mortgage for a rental property, they take on more risk than they do for a primary residence. This is due, in part, to the fact that landlords often use their rental income to cover the monthly mortgage payment. If the property is unoccupied for a period of time, the landlord isn’t bringing in rental income. For many property owners, a long-term vacancy would mean they can’t make their mortgage payment, which would cause issues for the lender. Therefore, lenders charge higher rates to shield themselves from this type of risk.

In most cases, rental property mortgage rates are roughly 0.50% to 0.75% higher than typical mortgage rates. Mortgage rates in early December fell to 2.92% for a 30-year fixed-rate mortgage on a primary home. As a result, you could expect the rate on a rental property to range from 3.42% to 3.67%.

The difference between these rates might seem minor, but it adds up over the life of a mortgage. Let’s say you borrow $300,000 in the form of a 30-year fixed-rate loan. If the mortgage loan was for your primary residence, you might get an interest rate as low as 2.92%. Over the 30-year life of the loan, you could expect to pay just over $150,000 in interest alone.

Now imagine that you took out the same mortgage for a rental property. You’ll be using the property as an investment, which means you’ll get an interest rate of 3.67%. Over the 30-year mortgage term, you would pay more than $195,000 in interest. That’s a full $45,000 more than you’d pay in interest at the lower residential mortgage rate.

[ Read: The Best Cities to Buy Rental Property ]

Down payment differences

In addition to the higher interest rate, rental property mortgages also typically require larger down payments. In most cases, the lender will require you to put at least 20% down when you buy a home.

According to a 2019 survey by the National Association of Realtors, the average down payment for all homebuyers is about 12%. When you look at just first-time buyers, the average down payment is just 6%. With a conventional loan, buyers can typically put down as little as 5%. With some government-backed loans and first-time homebuyer programs, minimum down payment requirements can be as little as nothing down to 3.5%.

For a rental property, the down payment requirements are a bit steeper. You’ll typically have to put down at least 15% on a single-family home. For multi-unit properties, the required down payment is likely to be at least 25%.

As with the higher interest rates, lenders ask for a larger down payment to account for the fact that investment property mortgages come with greater risk. Additionally, PMI isn’t attached to rental property loans with less than 20% down, meaning lenders can’t protect themselves in the same way they could on a mortgage for a primary residence.

Keep in mind that it may be in your best interest to put down an even larger down payment than is required by the lender. There’s often a correlation between the down payment and interest rate on a loan, and it will cut down on your monthly payment costs, too. As the size of the down payment increases, the interest rate often decreases, so putting more down on your rental property is always a good idea if you can afford to.

If you want to save money over the course of the loan, a larger down payment may help you to do so.

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